Wednesday, May 18, 2011

The FDR Framework and Ending The Looting of Banks

The other day, Bloomberg ran an interesting column by William Black.  One of the main observations in the column was

Nobel laureate George Akerlof and Paul Romer wrote a classic article in 1993. The title captured their findings: “Looting: the Economic Underworld of Bankruptcy for Profit.” Akerlof and Romer explained how bank CEOs can use accounting fraud to create a “sure thing” in the form of record short- term income, generated by making low-quality loans at a premium yield while making only minimal reserve allowances for losses. While it lasts, this fictional income allows the chief executive officer to loot the bank, which then fails, and walk away wealthy.
The necessary conditions for this fraud to take place are the limited access to the asset-level data made possible by the financial regulators' information monopoly combined with the regulators' inability to effectively analyze the information.

Everyone knows that the first condition exists as financial institutions are not required to disclose their current asset-level data.  For confirmation that the second necessary condition exists, see the WSJ article in which

[A] top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... that ... rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data.
As regular readers of this blog know, the FDR Framework would prevent this type of accounting fraud.  Under the FDR Framework, market participants have access to all the useful, relevant information in an appropriate, timely manner.  This is asset-level data for banks.

With access to the asset-level data, market participants, including competitors and credit/equity market analysts and investors, will do their own analysis of the risk of the assets.  It is this analysis that will show that the reserve allowance is not sufficient for the risk of the assets.

This type of accounting fraud is another way that the regulators' monopoly on all the useful, relevant information on financial institutions is harmful to the financial system.

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